Two of the Scariest Words in the English Language: Financial Innovation

Just a few years ago, much of the world applauded when former U.S. Federal Reserve chairman Paul Volcker told financiers that the only useful financial innovation they’d created during the previous two decades was the ATM.

After a real estate bubble and bust that had been assisted by impossibly complex financial instruments, Volcker’s words were a refreshing response to Wall Street’s humbug.

But today, writes Simon Nixon in The Wall Street Journal, “financial innovation is not just back in favor but a public policy priority.” Governments, eager to accommodate everyone’s demands of “cheap credit for all, a risk-free financial system and perpetual growth,” want banks to start lending more and get more credit flowing.

Image credit: Sean Ryan

The trouble, argues Nixon, is that governments are not encouraging innovation as much as a repeat of bad old tricks. “While the government talks about encouraging financial innovation, it has introduced a variety of new subsidies to reduce bank funding costs and encourage riskier mortgage lending that tilt the playing field against innovative new entrants,” Nixon writes. “Indeed, the biggest innovation arising from the crisis may be a shift from implicit guarantees for too-big-to-fail banks in favor of explicit guarantees and subsidies for politically favored groups.”

Certainly, as we’ve observed, none of this is the sort of innovation that Peter Drucker liked to see. In fact, Drucker shared a lot of Volcker’s skepticism about the financial industry. “The dominant financial services institutions have not made a single major innovation in 30 years,” Drucker wrote in a 1999 essay on financial services, published in Managing in the Next Society. “The only innovations have been any number of allegedly ‘scientific’ derivatives.”

Nonetheless, Drucker did believe that financial innovation was possible, potentially beneficial and even necessary. In his essay on the topic, he laid out a number of ways in which he felt large financial firms could benefit consumers. These included expanding the investment services offered to the middle class and offering outsourced financial management to midsize businesses.  And he saw plenty of merit in helping people to increase their purchasing power—provided it was done sensibly, as Cyrus McCormick did in the 19th century with installment purchases for farmers, and not just with reckless extensions of credit.

Was Drucker sanguine that such healthy innovation would happen? “It may not be too late for existing financial firms to become innovative again,” he wrote. “But it is surely very late.”

How can government policy encourage healthy financial innovation?